What is dividend stripping? Is it a sensible strategy?

With most stocks choosing to time dividend payouts with their financial results, investors chasing dividend stocks have little excuse for not getting onto the share register in sufficient time to benefit from the surplus cash that a company rewards shareholders with (typically) twice a year.

However, there’s another group of investors who time their share purchases just before a dividend is paid, with the express purpose of selling those shares after that payment (when they go ex-dividend).

This strategy is known as dividend stripping, and the end game – if played successfully – means investors can have their dividend, plus a transactional gain on their shares when they exit the stock. Interestingly, a perusal of historical dividend and share price data by Dividends.com.au concludes that dividend stripping of S&P/ASX200 index shares can provide a significant edge of more than 6 per cent over the S&P/ASX200 index for a holding period of 46 days – assuming simple guidelines are followed.

While dividend stripping can deliver a nice little earner for investors, it’s not for the faint hearted, and within today’s more volatile market, you need to tread carefully to prevent this investment strategy blowing up in your face. To put a dividend stripping strategy in the right context, let us walk you through exactly how it works.

Typically the domain of active share investors, dividend stripping is the art of buying the shares several weeks before the ex-dividend date in the hope that the share price will rally closer to this date as new investors (just like you) buy the stock – to capitalise on its dividend cash-flow – and then sell it after it goes ex-dividend.

By doing this investors hope to pick up the dividend, the imputation credit and a capital gain in one fell swoop, or at the very least a capital loss – smaller than the dividend gain – that can be used to offset gains elsewhere. Let’s take a look at a classic dividend stripping example.

How does it work?

To satisfy the 45-day rule, you buy a bank share 46 days before the ex-dividend date. What you’re hoping for is that the price will rise before the ex-dividend date, and generally speaking the bigger the dividend pay-out, the more likely this outcome is.

Share prices of Aussie banks typically run a month ahead of their results, and given where cash rates are at, income-investors are watching banks and other big income-plays (like Telstra) closely. As a case in point, ANZ’s entry price 46 days prior to ex-date in 2013 (9 May 2013) was $28.55, and ex-dividend closing price was $30.59, hence delivering a 10.8 per cent dividend strip return (46 days) and a 5.9 per cent edge over the S&P/ASX200 Accumulation Index.

In the normal course of events, the bank’s share price will rally ahead of

the results, and assuming the result is good, will continue doing so when the stock goes ex-dividend. You then proceed to sell the bank shares with your capital gain intact, having received the dividend, (and franking), and an entitlement to the imputation credit. You’re entitled to claim a tax credit equal to the amount of corporate tax paid by the company by holding the shares of a company for more than 45 days (not including the day of purchase or sale).

The trouble is that the less reliable the stock is as a dividend payer, the less bankable this strategy tends to be. So if the only people who bought the stock were dividend strippers, then there’s no underlying market support, and you risk the price dropping far more than the dividend.

What can go wrong?

Let’s look at a worst case scenario of how a dividend stripping strategy may play out.

In the lead up to reporting season (46 days out) you buy shares in a mining services provider with a consensus yield forecast of 14 per cent (fully franked). Prior to the result, the share price falls, and the dividend is subsequently cut because of disappointing results.

Given the small size of the dividend yield, you decide to hold on for the ‘ex date' only to find that the price continues sliding and when it goes ex 9 cents, the share price opens down 13 cents (the dividend plus the franking). At this point sellers outnumber buyers, the price falls 20 cents and surprise, surprise, after you finally sell – the share price starts to rebound.

Had you done your homework properly, you would have recognised:

A. that the company’s share price was already on a downward trajectory following an earlier profit warning a month before you bought in,

B. the stock only had a 14 per cent yield due to a falling share price, and

C. the pre-profit warning consensus dividend forecast was now out of date.

For tips on how to find high dividend stocks that can actually afford to pay a dividend click here. The lessons here are obvious: The value investing principles you apply to unearth quality stocks are just as relevant when choosing stocks for a potential dividend strip. Remember, you’re much better off buying quality stocks on an upward trajectory due to a rising market – that are incidentally going ex-dividend – than being swayed by a hefty yield or consensus forecasts that may only disappoint.

On an equally cautionary note, it’s important to remember that after going ex-dividend, a stock could typically be expected to fall by the amount of the dividend payment, with banks being among a few notable exceptions to this rule.

Admittedly, the share price recovery should be quicker for higher quality stocks, but the art of successful dividend stripping ultimately comes down to knowing when to enter and planning when to exit.